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IT’S WINTER FOR COLD STORAGE

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COLD STORAGE

Koine, Co-Founder, Phil Mochan

The emergence of new digital technology in finance has, somewhat ironically, brought back the terminology of a bygone era. Tokenised value (invariably held on a distributed ledger such as a blockchain) is now kept in “cold storage” (think physical safe), secured by digital keys and transacted by manual processes involving humans and “hot wallets” (think armoured cars).

The nature of digital assets is that the access layer to the value is via a private key, typically a string of alphanumeric characters that can be written down as a piece of paper or saved in a computer file. Digital assets can be compared to a credit card number without a pin or signature being required to authorise expenditure. They are bearer instruments: you hold them, you own them. A familiar bearer instrument is paper money, such as a £10 note. The difference is that the note, whilst having a unique serial number, also has number of additional anti-counterfeit measures. By contrast, the digital asset’s private key has no such measures and can be copied simply by recording it by hand, photographing it or accessing the computer on which it is stored.

Private keys are not only more vulnerable than conventional bearer instruments, such as cash, they also come in a highly portable format. A million pounds in cash will fit in in a modest suitcase. At ten million pounds, it starts to become burdensome and noticeable. By contrast, the same digital asset’s private key can equally hold one pound or a billion pounds, held on a slip of paper in a jacket pocket.

As the value of digital assets has grown exponentially since their emergence in 2008, to a peak of over 700 billion dollars, so has the risk around holding private keys grown dramatically – particularly when funds are exchanged through intermediaries. When paper certificates and cash were used by capital markets to transact 40 years ago, the model involved holding the paper in large physical bank safes and manually removing the transaction amounts using humans to transfer them to armoured trucks with guards.

Not only was this security model rather expensive (armoured vans, steel vaults and lots of people), it was also rather susceptible to internal collusion and theft. As Hollywood has demonstrated with its many heist movies, stealing from armoured trucks and safes is a popular criminal activity, with each subsequent movie seeking to explore a more elaborate and sophisticated way of stealing the money.

There have not yet been mainstream Hollywood movies depicting the opportunity for digital assets (“Bitcoin Big Bang”, a movie on MtGox was a rather niche production), but the press has covered a number of the more spectacular ones. It is estimated that the value of assets stolen in 2019 reached 4.4 billion dollars, up by 260% compared to the previous year (1.7 billion dollars)[1].

With digital assets, such as Bitcoin, hot wallets are the transitory accounts (funded from cold storage) used to settle investors transactions. “Hot” refers to the fact that these accounts are accessible through a public network. Other than that, there is no consistent definition in the industry in terms of the type and strength of controls required (or relaxed) compared to cold wallets. As investors have learned from a long litany of incidents, hot wallets are the preferred target for attacks.

The idea of treating digital assets as physical items reveals the teething issues of these new markets: a digital safe requires humans to interact with value. This renders settlement among market participants risky and inefficient, with many operational limitations.

Faced with similar issues – the risk of handling paper certificates – financial markets developed central securities depositories, institutions that maintain a record of ownership of assets, making the paper certificate irrelevant. The advantage of settling securities in this novel way proved immense: the risk of handling certificates – tangible objects – was eradicated, opening the way to the exponential growth of global securities markets.

COLD STORAGE

The growth of S&P 500 trading volumes over time

Investors in digital assets today are faced with material levels of operational risk, similar to those that forced securities markets to restructure their infrastructure with the dematerialisation of securities.

In the digital assets world, the current poor security model has come into focus in particular from regulators (such as SEC which has blocked insurance of Bitcoin ETF due to lack of effective custody solution) and for institutional capital, which seeks an insured and safe digital asset market which conforms to the expected norms of a trading environment.

Market Infrastructure providers to digital asset markets have been slow in addressing this risk.  Controls over private keys (the physical element kept in hot or cold storage) have been strengthened with elegant technology – better safes, better armoured tracks and more people – but little has been done to tackle the principal issues inherent with the handling of bearer assets. Multi-signature accounts or multi-part computation are often cited as effective solutions. These controls are the digital version of better physical safes or armoured tracks, but they remain ineffective against internal collusion – the primary cause of loss for investors. Furthermore, the manual handling of keys significantly limits scalability and performance of settlement processes.

The cryptocurrency Bitcoin was initially devised to deprive intermediaries of their dominant role in the management and transfer of value yet, ironically, intermediaries are still dominant, they are just new (and probably riskier). The dream of anonymity and disintermediation from centralised trusted parties as imagined by the creators and many supporters of Bitcoin, has given way to hard practicalities of delivering effective security, operational efficiency and meeting the regulatory requirements.

Therefore, in this new environment, centralised trust will continue to be an essential feature to ensure that these new digital markets function efficiently.  Fundamentally it comes down to trust in the custody of assets, when investors are required to delegate its safekeeping to an independent party, and trust in the settlement of transactions, to an agreed set of standards with certainly of timely legal finality.

The digitalisation of assets will in future bring frictionless value transfer and riskless trade matching.  This will evidently require improved conventional market models using dematerialised digital assets, operating with a full separation of duties model, with DvP settlement and using digital CSDs.

Digitalisation will undoubtedly increase the investible universe of assets available to capital (be it property, collateralised debt or digitalised art), increase the accessibility of those assets to a wider range of investors, and create greater fluidity (price transparency, low cost execution and buy-side access) when it comes time to sell.  We can foresee that digital custodians, using dematerialised business models, will grow to become the dominant providers in a rapidly growing market for holding safe, all digital value. This, we believe, will prompt an exponential growth in trading volumes and, particularly in stressed market situations, a considerable reduction in systemic and trading risks.

[1] See CipherTrace report https://www.businesswire.com/news/home/20191127005510/en/

 

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CBDCs: the key to transform cross-border payments

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Dr. Ruth Wandhöfer, Board Director at RTGS.global

 

If you work in finance, you’ll have been hearing a lot about central bank digital currencies (CBDCs) and the moves different markets are making towards using, regulating and evaluating the viability of moving to an economy based on digital currency.

We are already seeing progress in the research, piloting and introduction of CBDCs into the financial system. The Banque de France for example, recently launched its second phase of CBDC experiments in line with the “triple digital revolution” unfolding in the financial sector. The infrastructures of financial markets and fintechs, however, are not prepared to accommodate their security, stability, and viability.

This could be an issue in the not too distant future. Each year, global corporates move nearly $23.5 trillion between countries, equivalent to about 25% of global GDP. This requires them to use wholesale cross-border payment processes, which remain suboptimal from a cost, speed, and transparency perspective. In fact, the G20 cross-border payments programme considers improving access to domestic payment systems that settle in central bank money, as one of the key components in facilitating increased speed and reducing the costs of cross-border payments.

The current state of cross-border payments

International transactions based on fiat are currently slow, expensive, and highly risky due to today’s disconnected financial infrastructure, messaging, and liquidity. Wholesale cross-border payment settlement can take 48 hours or longer, which is not practical in today’s digital world. Even if not every market moves to CBDCs, in an increasingly digital era, cross-border settlements between central banks will unavoidably involve dealing with CBDCs. So, not only will we have different currencies, we’ll have different technical forms of currency being exchanged – digital and fiat – as markets adopt CBDCs at different rates, adding another layer of complexity to cross-border settlements.

While there is much anticipation about the opportunities CBDCs can bring, the adoption of this technology will only be widespread if payment and settlement capabilities are overhauled to allow for new innovations in currencies.  This need for transformation represents an opportunity to redesign existing infrastructure to support cross-border CBDC transactions.

The current cross-border payments system involves correspondent banks in different jurisdictions using commercial bank money. Uncommitted credit lines used in cross-border transactions are a potential risk for any bank that relies on credit provided by a foreign correspondent bank. Interestingly, there is no single global payment and settlement system, only a complicated network of interbank relationships operating on mutual trust. While trust has allowed financial systems to function smoothly, when it begins to fail, as it did during the 2008 financial crisis, the result can be catastrophic.

Following the crisis, the Bank for International Settlements (BIS) implemented the Basel III agreement, which required banks to maintain additional capital against correspondent banking account exposures. These risk-weighted assets impose a costly capital charge on positions held by banks at other banks under correspondent arrangements. While this framework helps combat risk, it neglects to address the inherent problems in traditional correspondent banking that contribute to these risks.

Making the case for CBDCs

CBDCs can offer an improvement in settlement risks and are certainly thought to have potential benefits by the BIS. If implemented correctly, wholesale CBDCs can indeed accelerate interbank transactions while eliminating settlement risk. They can also encourage a more efficient and straightforward method of executing cross-border payments by reducing the number of intermediaries.

It is likely the evolution towards CBDCs will initially see the financial market supplement rather than replace existing payment instruments with new types of digital currency. CBDCs will coexist with current forms of money in a wholesale context, and their payment rails will also work alongside the existing payment systems. In simple terms, CBDCs will need to be linked to the broader capital markets ecosystem and applications such as securities settlement, funding, and liquidity.

If built with an innovation-first mindset, the future of banking infrastructure should provide full interoperability and convertibility between fiat, CBDCs, and any other type of digital money used in wholesale payments.

The future of CBDCs

To unlock the full potential of CBDCs, a ‘corridor network’ will need to be formed. This involves combining multiple wholesale CDBCs into a single, interoperable network under common governance agreed upon by all central banks involved. The legal framework of this platform would then allow for payment versus payment (PvP) or, where applicable, delivery versus payment settlement.

Practical wholesale CBDCs appear to be on the horizon, either as a supplement to existing financial systems or as part of a transition to a digital, cashless world. Looking ahead, central banks would benefit from collaborating with fintechs that provide innovative cloud native technology to enable seamless wholesale cross-border payments without interfering with the flow of funds. If wholesale CBDCs are to become a reality, fintechs must be prepared to accommodate them.

 

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Green growth: The unstoppable rise of climate technology investment

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With the investment community focusing more and more on renewable technologies, investor interest is at an all-time high. Ian Thomas, managing director, Turquoise, reviews the current investment landscape and highlights the opportunities for investors keen to capitalise on this growing trend.

Green, or climate, finance is a label for providers of finance who are supporting investments seeking positive environmental impact. The label covers investments in green infrastructure, venture capital investment in clean technologies and renewable energy. Green finance has grown by leaps and bounds in recent years, supporting public wellbeing and social equity while reducing environmental risks and improving ecological integrity.

Worldwide, energy investment is forecast to increase by 8% in 2022 to $2.4 trillion, according to a new report by the International Energy Agency, with the expected rise coming mostly from clean energy – $1.4 trillion in total. To put this rocketing figure into some perspective, clean energy investment only rose by 2% annually in the five years following the signing of the Paris Agreement in 2015. Energy transition investment has some way to go, however – between 2022 and 2025, to get on track for global net zero, it must rise by three times the current amount to average $2,063 billion. [1]

Turquoise has been active for almost 20 years as a venture capital investor and adviser to companies in the climate technology space that are raising capital and/or selling their business to a strategic acquirer. Reviewing current industry investment news, as well as drawing on examples from the portfolio of Low Carbon Innovation Fund 2 (LCIF2), managed by Turquoise, I have commented below the latest on the renewable energy trends most piquing investor interest.

 

Solar PV

Renewable power is leading the charge when it comes to investment, with wind energy and solar PV emerging as the cheapest option for new power generation across many countries, and now accounting for more than 80% of total power sector investment. Solar power is responsible for half of new investment in renewable power, with spending divided roughly equally between utility scale projects and distributed solar PV systems.

This huge increase in solar spending, which continues in spite of supply chain issues affecting raw material delivery, has been driven by Asia, largely China (BloombergNEF, 2022). Meanwhile, Europe is re-doubling its efforts to achieve an energy transition away from Russian gas and other fossil fuels, building on investment that was already rising steadily prior to the outbreak of war in Ukraine. Germany, the UK, France and Spain all exceeded $10 billion on low-carbon spending in 2021.[2]

 

Wind

Last year was a record year for offshore wind deployment with more than 20GW commissioned, accounting for approximately $40 billion in investment. The first half of 2022 saw $32 billion invested in offshore wind, 52% more than in the same period in 2021 (BloombergNEF, 2022). Taking into account also onshore wind, in 2021 investment was spearheaded by China, followed by the US and Brazil.[3]

In the UK, suggested targets include plans to host 50GW of offshore wind capacity, as well as 10GW of green and blue hydrogen production, by 2030. Investors will naturally be encouraged by proposals to simplify the planning process across the board for renewable projects.[4] France and Germany have also increased their offshore wind targets, signalling further support for investment.

 

Decarbonising housing: the business opportunity

The need to decarbonise residential housing, made all the more urgent by current energy prices, also offers substantial scope for investment. The gas price spike is naturally increasing interest in technology such as electric heat pumps, which had already enjoyed 15% growth in 2021 albeit from a very low base.

Recently, Turquoise announced an investment by Low Carbon Innovation Fund 2 (LCIF2) in Switchd, which operates MakeMyHouseGreen, a data-driven platform that allows homeowners to source and install domestic renewable energy generation, including solar panels and battery storage with other energy saving products in the pipeline. The investment will enable Switchd to roll out the MakeMyHouseGreen platform to a much larger number of customers. The latest episode of the Talks with Turquoise podcast series saw us interview Switchd co-founder Llewellyn Kinch about the UK energy market and national transition to decarbonisation, covering the rise of residential renewable energy and energy efficiency.

 

Adapting to the low-carbon economy

Meanwhile, investors should not forget opportunities on the other side of the energy market. Renewables are undoubtedly exciting investors, but there are also opportunities for fossil fuel companies to adapt their business models to the low-carbon economy. Turquoise advised GT Energy, a portfolio company from our first fund that develops deep geothermal heat projects, on its sale to IGas Energy, a leading UK onshore oil & gas producer. Under IGas ownership, GT Energy will progress its flagship 14MW project to supply zero-carbon heat to the city of Stoke-on-Trent through a council-owned district heating network.

 

A broad investment landscape

Forecasts show that renewables will increase to 60% of power generation in Europe by 2030, and 40% in the US and China by the same date.[5] As demand rises for climate technology, the investment opportunities in green finance are far broader than they ever have been. Undoubtedly, as the energy crisis continues, investor interest will continue to soar to even greater heights.

[1] https://www.iea.org/news/record-clean-energy-spending-is-set-to-help-global-energy-investment-grow-by-8-in-2022
[2] https://ihsmarkit.com/research-analysis/global-power-and-renewables-research-highlights-july-2022.html
[3] https://dialogochino.net/en/uncategorised/56938-global-wind-energy-council-vice-chair-brazil-offshore-wind-accelerating-2/
[4] https://www.edie.net/uks-clean-energy-investment-ranking-rises-after-government-sets-95-low-carbon-electricity-target-for-2030/
[5] https://www.spglobal.com/en/research-insights/featured/energy-transition-renewables-remain-the-cornerstone-of-future-power-generation

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